UK zombies shuffle onwards

March 2013 | FEATURE | BANKRUPTCY & RESTRUCTURING

Financier Worldwide Magazine

March 2013 Issue

The undead have enjoyed something of a renaissance in recent years. After virtually disappearing from the mainstream consciousness for decades, we are now fully accustomed to seeing zombies in video games, on our television screens and in cinemas once again. However, despite whatever the silver screen would have you believe, the only threat zombies pose is an economic one.

Since the onset of the financial crisis ‘zombie companies’ have entered common parlance in financial circles, and we have seen a considerable rise in the number of ‘undead’ businesses in recent years. Zombie companies are businesses which, from a financial perspective, are neither alive nor dead. While they can just about service the interest payments on their outstanding loans, zombies are left with no additional capital to pay off the debt itself.

Although the company can service its debt, the lack of available cash dictates that zombies cannot invest, innovate or grow their businesses. Zombie companies, therefore, exist in a state of limbo; with the banks unable pull the plug and the company unable to expand. Accordingly, these types of companies can be considered half alive, insomuch that they are meeting their financial obligations. However, as they are unable to record any growth or pay off their loans, they can also be deemed to be half dead.

And the spectre of zombies is not just confined to the business world. The financial crisis has also brought about an increasing number of zombie households; similarly to zombie businesses these are households that are able to service payments merely on the interest of their mortgages alone, rendering the original loan untouched. Should interest rates rise back to normal, established levels, many of these undead households would be unable to service their debt. Furthermore, financial constraints mean that these households have no real spending power and therefore no way of boosting the sluggish economy via consumer spending.

Cannibalising the economy

The significance of, and the appropriate response to, zombie companies has been hotly debated for some time. However, the explosion in numbers of affected firms cannot be contested.

According to research conducted by insolvency trade body R3, there are now at least 160,000 zombie companies operating in the UK. This number represents an incredible 9 percent of all businesses in the country. R3’s data states that the number of affected companies has leapt by 10 percent since July 2012. A consequence of record low interest rates, government bailouts, and ultra-loose monetary policies and forbearance by banks since the onset of the financial crisis, some fear that zombie companies are cannibalising the UK economy, hindering growth.

Zombie companies have benefited from banks unwilling to crystallise losses on their books and policy makers looking to protect jobs rather than boost efficiency. Spencer Dale, chief economist at the Bank of England (BoE), told the Financial Times “To some extent, that’s exactly what we want to happen, that’s the whole point of monetary policy loosening at the moment – to keep companies that have a viable long-term future in business while demand is temporarily weak.” The sealing up of much needed resources in zombie companies goes a long way towards explaining the low productivity growth seen in the UK since the financial crisis began. The British economy has not yet realised the level of output it enjoyed in 2007 before the start of the financial crisis, yet despite the nation’s poor economic performance, unemployment has remained comparatively low when compared with previous recessions, resulting in a collapse in productivity. The BoE has previously expressed concerns that the UK’s productive capacity may have been indelibly damaged by the crisis.

A 2012 Ernst & Young report suggests that the financial crisis created an environment where it is ‘too difficult to fail’. To that end, while roughly three out of every 10 UK companies are now making a loss – more than during the recession of the 1990s – there are fewer companies succumbing to insolvency. In 2012 the BoE estimated that fewer than 17,000 companies were declared insolvent; considerably less than the 25,000 businesses declared bankrupt in the ’90s. In light of the growing malaise within the British economy, in November 2012 Sir Mervyn King, governor of the BoE, noted that Britain “may be in for a period of persistently low growth”.

Under normal circumstances, unproductive, unsuccessful companies should collapse as interest rates rise, thereby releasing capital to more fruitful areas of the economy, creating jobs in the process. However, according to Alan Bloom, global head of restructuring at Ernst & Young, “The fundamental tenet of capitalism, which holds that some bad companies need to fail to make way for new and better ones, is being rewritten. Many European companies are just declining slowly and have an urgent need for new management, a revised capital structure or at worst to be allowed to fail.”

Lee Manning, president of R3, shares this view. In a statement released by the body he noted that “Low insolvency rates are good for employment, and our relatively flexible insolvency regime has allowed many insolvent businesses, especially in the retail sector, to emerge from administration with some jobs or stores intact. However, corporate insolvencies have traditionally tended to spike in early recovery, but so far this recession is re-writing the rules. This surely reflects this longer period of low growth that is the new norm, with low interest rates and low liquidation rates, but many businesses running at a loss.”

Delaying the inevitable

How best to tackle the zombie epidemic is a divisive subject between policy makers. While there are many analysts that feel that mainland Europe and the UK need to adopt a hard-line stance towards the problem, there are others who suggest that while the proliferation of zombie companies is detrimental to economic growth, the stability and employment offered by these companies is more desirable than further mass unemployment. There are currently hundreds of thousands of jobs tied up in UK zombie businesses alone. A cleansing of these companies would therefore lead to huge job losses. Derek Sach, head of restructuring at Royal Bank of Scotland, told the Financial Times “The main people who promote a tougher stance on struggling companies are the vulture funds and the advisers who think they will get more work… My judgment is that the pain has been about as much as you can take without civil unrest”.

There are also additional benefits for the banks themselves in allowing heavily indebted zombies to continue trading. Primarily, they can delay the hit to their own balance sheet which occurs when a firm eventually collapses. Several Europeans banks have themselves been bailed out since the crisis and are therefore under increasing pressure, particularly from the IMF, to effectively manage and clean up their own balance sheets.

Moreover, some of the most profitable companies in the world have experienced periods in their history when they might have been considered zombies. Companies such as Lego, Ford and Apple have all endured difficult financial periods only to emerge as some of the most profitable companies in the world. Apple alone reported net quarterly profits of $8.8bn in Q3 2012.

US treasury secretary Andrew Mellon during the Great Depression urged central banks to “Liquidate labour, liquidate stocks, liquidate real estate… it will purge the rottenness out of the system” noting that this course of action will enable “enterprising people (to) pick up from less competent people”. Martha Gill in the New Statesman is opposed to this approach, however, arguing that it is a zombie economy, not zombie companies, which has caused poor sales and low profitability. She points out that “Spending levels are low right now, so companies which might not ordinarily deserve to go to the wall are struggling”. As such, any movement by banks and regulators to pull the proverbial plug on zombie companies will only exacerbate the wider problem.

Creative destruction

Despite the obvious employment benefits, many analysts suggest that zombies strangling the economy and hindering its prospects for growth should be allowed to fail. Certainly, under more traditional economic conditions these companies would have collapsed long ago. Any such collapse would free up capital that was previously locked in insolvent companies, to be allocated to more viable companies in need of financing. The BoE in October noted that “Some companies may have been able to remain in operation during the recession [as a result of government and central bank action]”, and that this might have “hindered the reallocation of capital towards more productive sectors”.

Conventional thinking suggests that once zombies are allowed to reach their natural conclusion, their market share would be soaked up and better distributed among healthy, profitable businesses, thus fuelling economic growth. It has been forecast that, as sales continue to decrease and costs rise, insolvencies, particularly in small scale property and construction companies, as well as hotel and leisure businesses in particular, will increase in 2013.

In the interests of the wider economic recovery it would seem sensible that European and British banks learn the lessons of the Japanese recession of the 1990s. The so called ‘lost decade’ after the collapse of the Japanese asset price bubble led to the proliferation of both zombie banks and zombie companies in Japan. Low inflation rates, easily available credit, and the failure of the banks to foreclose on indebted companies ground the Japanese economy to a halt, leading to two decades of economic stagnation and spiralling debt-to-GDP ratios. In many ways the nation’s economy has never really recovered. There are still many Japanese zombies in operation and it is estimated that around two-thirds of Japanese businesses do not earn a taxable profit. Furthermore, the economic stagnation experienced within the Japanese economy has led to a vicious cycle of central government stimulus – the latest stimulus package, of approximately $116bn, was announced in January.

The Austrian-American economist Joseph Schumpeter popularised a Marxist theory in the 1940s, in which he describes capitalism as being a “process of industrial mutation that incessantly revolutionises the economic structure from within, incessantly destroying the old one, incessantly creating a new one”. He further postulates that the “process of creative destruction is the essential fact about capitalism”. In essence Schumpeter and Mellon are singing from the same Darwinian hymn sheet. By allowing the weak to be removed from the market place the strong will prosper. Essentially, both men theorise that economic growth is built upon the rubble of previous failures. While creative destruction may not be popular as a theory, as its ruthless approach advocates job losses, the collapse of companies such as Hostess Brands and Kodak in the US has lent the theory new credibility.

One of the UK’s largest electronics retailers Comet collapsed in December 2012, leading to approximately 7000 job losses. In January 2013 Comet’s historical rival Currys reported like-for-like sales were up 8 percent over the 12 weeks to 5 January. This, surely, is creative destruction in action. While zombie companies may provide stability and employment to many, it is not until they have been slain that we will see the shoots of new economic life coming into view.